The Growing Popularity of Peer-to-Peer Loans

The credit crunch has had many effects on the state of the American economy: bankruptcy filings are on the rise, foreclosure rates are skyrocketing and loans are becoming more and more difficult to secure. But, being Americans, we as a nation are finding ways to cope with - and even benefit from - tighter consumer credit.

According to BusinessWeek and USA Today, the latest trend among Americans in need of loans is what's known as peer-to-peer lending, or person-to-person lending. Read on for some background on peer lending and how you can get involved.

What is Peer Lending?

Peer loans are exactly what they sound like: one person lends money to another. Basically, it's just like any other loan, but the formal banking institution has been taking out of the mix. Because of the Internet's ability to connect people and serve as a transactional tool, peer lending has come into its own online. Here are the two basic types:

Marketplace Peer Lending: Borrowers post how much money they need and the interest rates they're willing to pay. Lenders then "bid" on all or part of a loan, and the borrower can select the lender/lenders offering the lowest interest rate.

Friends & Family Peer Lending: These sites act more as venues to formalize loans between people who already know each other, which can help people avoid those sticky why-are-you-six-months-late-on-that-loan-I-made-you conversations over Thanksgiving dinner. Basically, these companies service and regulate loans.

The Benefits of Peer Lending

With consumer credit hard to come by these days, peer lending provides borrowers with much-needed access to loans. Plus, their format provides a few benefits that traditional loans don't offer.

(Potentially) lower interest rates: Because of the auction-style lending sites (which USA Today calls "the eBay of consumer loans"), borrowers have a shot at getting interest rates lower than the 6-16% typical for regular consumer loans. But interest rates usually still depend on a borrower's credit score.

Higher returns for lenders: Because there's no "middleman" taking a cut, lenders stand to make more from their loans than they would through traditional banking institutions.

Needed alternative for college students: With even big lenders like Sallie Mae and Citibank limiting student loans, and 20% of private student lenders having pulled out of the market, those looking to fund their educations are in need of cash. Some peer lending sites are specifically designed for students; others offer student-geared products.

Sense of duty/camaraderie: One of the theories supporting peer lending is that smaller scale operations like this foster lower default rates: borrowers are less likely to default when they're borrowing from an individual rather than a corporate giant.

The Drawbacks of Peer Lending

Like anything else, peer lending is ultimately a mixed bag. The small-scale setup that forms much of the appeal of peer loans can also prove unsavory when borrowers default.

Unknown risk level for lenders: Since peer lending is fairly new, no reliable figures exist for determining the likelihood that a borrower will default on a loan. The potential returns for lenders are higher than those from a traditional bank, but so are the potential losses.

Loss protection means smaller gains: Some sites offer partial or complete guarantees on their loans, but for that insurance, they collect part of the lenders' potential profit. Even with these protections in place though, potential returns are still higher than those of banks.

Some loans aren't feasible for students: Many sites require loan payments to start immediately, which can prove tricky for full-time students. Also, while interest rates tend to be lower, fees for missing payments can be high, which can hurt borrowers.

But lenders and borrowers can work around these potential pitfalls. Some lenders reportedly spread out their capital, lending small amounts to various borrowers, so they're only minimally hurt by any individual's default. And borrowers, as always, can shop around to find the best rates available.